Covering the mortgage, part 2

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To get a little less abstract than the previous post on the application of housing law during financial meltdown, I think I've satisfactorily chewed over a connection I've been working on.

A week ago, I attended the Global Suburbs conference at UMich (in no small part masterminded by Dale), and caught part of a talk on land ownership and housing costs in Lahore, Pakistan. If I followed correctly, one comment that was made was that Pakistanis had fairly recently received access to financing tools such as the 30-year mortgage, allowing many people the potential to purchase homes who never would have been able to previously. This increased buying power led to increased demand, contributing to rising prices.

There's a parallel here. Over the past decade, Americans have received access to financing tools such as the ARM, the zero-down mortgage, the interest-only mortgage, the no-documentation mortgage, and all sorts of bizarre hybrids. All of these were essentially justified by lenders on the grounds that mortgages were a can't-lose proposition, as well as the adoption of collateralized debt instruments, and allowed many people the potential to purchase homes who never would have been able to previously.

Can it be that home prices kept rising in part because these new financing tools served to increase buying power, increasing demand and driving up prices? Yes, I think that could certainly be a part of it, though I've never heard it explicitly stated. It's not a big leap - it's recognized that low interest rates drive up prices, as, holding income constant, spending less on the interest portion of your payment allows you to spend more on the principle.

So here we had a positive feedback loop: risky financial tools justified on an assumption of rising home prices, when the rising prices were themselves driven in part by the use of those financial tools, which leads to the conclusion that the price increase would last only until the financing tools started breaking. Oops.

But that's only half the thought I've been pondering.

Over the weekend, I noticed that the house two doors down has come out of the foreclosure redemption period, and the bank was offering it for sale. At $61,000, it was an absolute steal: we'd previously been tempted by the house immediately next door, when the bank offered that one for $65k, but this is a house twice the size, on a lot twice the size, containing four single-bedroom apartments. I plugged a randomly chosen $40k in rehab costs into my spreadsheet, as there was a fire over the summer that damaged two of the four apartments, and came to the conclusion that, yes, indeed, this would be a good investment, even excluding the value of choosing my neighbors - I'd be able to make money while charging under-market rent.

The problem was that I don't quite have the liquidity to implement this plan, even though a neighbor seemed interested in the idea of co-investment. We'd be able to handle it, but at the cost of, say, remodeling our bathroom. (AAiO: yes, I'm truly on that side of the fence, aren't I?) Additionally, by the time the listing agent called me back, they'd already accepted an offer.

A few days later, I had the opportunity to talk to the landlord who beat me to the house, and commented on it being a good deal. "If they keep giving them away, I'll keep buying them," he responded.

And here's where we hit the second positive feedback loop of the post: the banks are selling houses as fast as they can. Houses in my neighborhood seem to be under contract within a week of being listed by the bank, because the banks are asking only half what they've got on the mortgage, desperate to unload them.

Meanwhile, you hear people complain that "nobody's buying houses." Untrue - lots of people are buying houses. There've been bidding wars in my neighborhood with people rushing to pick up houses - because the banks are offering them so low.

The problem is that the people who were lured into using those risky new financial instruments to buy houses they really couldn't afford generally don't have the option to offer their houses at half the value - they see their mortgage balance as an absolute floor, and just can't compete with the banks' liquidation pricing. With the banks sucking the air out of the room by offering amazing deals to buyers, it gets more difficult for anybody else to sell a home, and some of those people end up in foreclosure because they can't sell their homes - feeding the cycle with more bargain sales.

The housing market therefore can't "recover" until the foreclosure wave stops - which probably won't happen until a sizable portion of those unconventional mortgages have been pushed into foreclosure by this viscous cycle and been sold again. Scared yet?

On the upside (a slim one), I think all of the "market correction" that we're seeing was going to happen anyways, eventually. And if the liquidation of foreclosures makes that correction happen more quickly, then we can be on the other side and start putting the pieces back together again. Note that I'm not saying, "recover", because, again, I don't think we're going back to where we were; I just think we need a little bit of stability in order to figure out just what the new normal is.

(In the meantime, I am daily thankful for our decision not to "buy the most house we can afford", but rather "the cheapest house that would make us happy.")